RBI policy warns of amplified global risks - Views on News from Equitymaster

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RBI policy warns of amplified global risks

Jun 16, 2011

The Indian central bank declared its second monetary policy for the financial year 2011-12 today. Skyrocketing commodity prices and inflationary pressure forced the RBI to tighten its monetary policy stance once again. The RBI continued its rampage against the persistent inflation by resorting to interest rate hikes for the 10th time in 15 months.

The interest rate at which the RBI lends to (repo rate) banks was raised by 0.25%. Thus the repo rate now stands at 7.5% from 7.25% previously. The rate at which RBI borrows from banks (reverse repo), has been pegged at 1% below the repo rate. Thus, the reverse repo rate has automatically adjusted to stand at 6.5% from 6.25% previously.

The increase in the price of commodities globally was cited as the ‘key risk factor' troubling the RBI. A slowdown in the pace of global growth is as much worrying. Uncertainty about the resolution of the Euro debt crisis has already spooked equity markets several times. Economies have been reeling under the pressure of high crude oil prices as well as other commodities. Now despite slower GDP growth prospects and lower consumption levels, commodity prices are still far from being at comfortable levels. Higher domestic demand, and increased input costs, has led to inflation in emerging economies to consistently be on the rise. Tighter monetary policies in Asian economies, particularly India and China, are yet to yield the desired results.

Is growth slowing down?

Growth in India's Gross Domestic Product (GDP) saw a slowdown to 7.8% in the fourth quarter of the financial year 2010-11 (4QFY11) from 8.3% in the previous quarter. The GDP growth had come in at a higher level of 9.4% in 4QFY10 before the rate hikes started. The RBI's latest round of liquidity tightening therefore begets the question as to whether India is headed towards a recession?

A recession is a period of a temporary decline in economic activity and consumption. Trade and industrial activity see a slowdown. It is usually identified by a fall in GDP for two quarters, back to back.

Interest rate sensitive sectors such as automobiles, housing etc. are witnessing a visible slowdown. Index of Industrial Production (IIP) numbers also saw a decline in April 2011. Credit growth for banks has seen some moderation. As companies deferred their capex plans, credit growth slowed down from 21.3% YoY in March 2011 to 20.6% YoY by early June 2011. However, this is still higher than the RBI's projection of 19% growth for the fiscal. 47 banks raised their base lending rates by 1.5-3% from July 2010-May 2011, in line with the RBI's aggressive stance. Bank funding is a major fuel to the economy. Now, with higher borrowing costs, not only can demand for credit moderate but also have a cascading effect on other growth aspects of the economy like consumption and investment.

Going forward

Inflationary pressure may continue to plague the Indian economy in the near term. While supply of food products may get eased with good monsoon, the non agricultural commodities may remain a cause for concern. Inefficient supply chain and pricing mechanisms may also hurt consumer inflation. This indicates that rising input costs and higher wage levels could be passed on by producers. With little option to rein in price levels that can lead to real growth rates remaining in the negative, the RBI may not stop tweaking its monetary tools whenever necessary. However, the RBI will be looking closely at global developments and try and balance its anti-inflationary stance accordingly. Either way, things do not look too rosy for the economy at this point.

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